SEP: A Terrific Tool to Increase Retirement Savings and Minimize Taxes
Self-employed business owners can reduce their taxes and greatly increase retirement savings with a Simplified Employee Pension (SEP) IRA.
These plans are one of the best retirement plans available for self-employed business owners. They operate like an IRA with the added bonus of higher levels of tax-deductible contributions.
What is a SEP?
A SEP IRA is an account established by a small business owner to make pre-tax contributions for retirement. Since you contribute pre-tax dollars to a SEP IRA, you will lower your taxes.
As with traditional IRAs, any interest generated by your SEP account is also tax-deferred.
These accounts are easy to set up, effortless to maintain, and operate similarly to a traditional IRA. The IRS regulates these accounts with rules similar to rules for IRA investment, distribution, and rollovers.
You will pay taxes when you withdraw funds based on your income tax rate at the time of your withdrawal. Moreover, you will likely incur a penalty if you withdraw funds prior to age 59 ½.
Small business employers can also use these accounts to provide retirement contributions for employees.
How much can you contribute to a SEP in 2018?
When compared to a traditional IRA, the SEP IRA enables business owners to make much higher contributions. This higher level is a key advantage of the SEP IRA. For the 2018 tax year, business owners can contribute as much as:
- 25% of their gross annual salary, up to a cap of $55,000, or
- 20% of their net adjusted annual self-employment income, also up to $55,000*
*To calculate your net adjusted annual self-employment income, you must use a special formula and it’s a little complicated.
If you are self-employed, you must base your contribution on your net profit – minus one-half of the self-employment tax – minus your SEP contribution. For more information, visit this page on the IRS website.
You can also use a free calculator on Vanguard’s website.
SEP Contribution Requirements for Small Business Employees
If you have eligible employees, your contribution percentage to their SEP accounts and your SEP account must match. Employees of your business are eligible for SEP contributions if they:
- Have worked for you for three of the past five years
- Received more than $550 in compensation, and
- Are older than 21
Employees can also contribute to their SEP accounts. Unlike other company-related retirement plans, the SEP is an individual retirement account. Your company will sponsor the plan, but employees included in the plan will manage their own accounts. With this feature, you avoid any fiduciary responsibility for managing your employees’ retirement funds.
Contributions Are Discretionary with Flexible Deadline
Another advantage of a SEP account is that you elect in what years to contribute. You can vary the percentage contribution from year to year based on how well your business is performing.
Just remember, if you have employees, you must offer them the same contribution percentage as the one you take.
Unlike traditional IRAs, you do not need to contribute to a SEP IRA by April 15. If you file an extension, you have until that deadline to contribute.
Setting Up a SEP IRA Program
It is very straightforward to set up a SEP IRA program. You will do this through a third party (a bank, an investment brokerage company, a mutual-fund company, etc.) If you have employees, you must follow rules on reporting your contribution plan.
You can contact your preferred financial entity for more information. You can also get information on establishing a SEP at the IRS website: https://www.irs.gov/retirement-plans/establishing-a-sep
If you have any questions, please let us know.